When Do You Become A Landlord?

There is a requisite to being an NFL player – current or retired.

You must have played in the NFL.

There is a tax spiff on this point when you decide to landlord.

When does your rental start?

Probably when you place it in service, that is, when you have a tenant and begin receiving rent.

Can it start before then? Say that you are having trouble getting a tenant. Can you can say that you started renting before you have a tenant?

It probably can happen, but you had better line-up your facts in case of challenge.

I am looking at a case where the IRS assessed the following tax:

                 2004             $ 78,292

                     2005             $144,053     

                     2006             $218,228

                     2007             $143,729

                     2008             $252,777

                     2009             $309,060

Numbers like that will attract attention, the kind that can result in a challenge.

There is a doctor who now lives in Florida but used to live in Rhode Island. In 2004 he and his wife bought a mansion in Newport. The house was derelict, having been vacant for four decades.

It was uninhabitable, so the first thing they did was bring in a contractor.

It was a historic property, so there were also some tax credits in there.

Restoration started in 2002.

The work went into 2008.

That is a lot of restoration.

The family moved to Florida in 2005.

I suppose that answers the issue of whether this was ever a principal residence. It could not be if one could not live in it.

In 2006 they met a rental agent who specialized in luxury properties.

They got a temporary certificate of occupancy in 2007 and a final certificate in 2008.

Seems that one could argue that it was available for rent in 2007.

By 2007 the agent was hopeful she could attract a renter. She held up actively marketing it, however, as renovations were unfinished.

Sure enough, one of her clients expressed an interest in 2008.

The debt on this fiasco was ballooning, so the doctor and his wife decided to dump the house. The ante was upped when the bank increased their monthly payment in 2008 from $25 grand to $39 grand a month.

Count me out on ever renting this place.

In July, 2009 they sold the house.

They filed their 2009 tax return and reported a capital loss of a gazillion dollars.

Tax advisors are not overly fond of capital loses, as the only thing they can offset – with one exception – is capital gains. If you have no capital gains, then the loss just sits there – unused and gathering dust.

The doctor and his wife met a tax advisor who said that he could help: just treat the house as business property and the loss would be deductible. The good kind of loss – the kind you can actually lose.

They amended their 2009 return and reported a $8-plus million business loss.

Now they had a 2009 net operating loss. They carried the loss backward and forward. There were tax refunds and jollity aplenty.

However, numbers like that attract IRS attention, especially when you amend a return.

The IRS did not believe they had business property. If it was not business, then the initial reporting as capital loss was correct. The IRS wanted its money back.

Don’t think so, replied the doctor and his wife.

Off to Tax Court they went.

At issue was whether the house ever shifted to rental status, as that is the trigger for it to be business property.

There was one key – and punishing – fact: they never rented the house.

Here is the Court:

While we have no doubt that petitioners devoted a great deal of time, effort and expense to the renovation of Wrentham House Mansion, the record overwhelmingly confirms that Wrentham House Mansion was never held out for rent or rented after the restoration was complete. Quite simply, the rental activity with respect to Wrentham House Mansion never commenced in any meaningful or substantive way.”

Perhaps the doctor and his wife would have held on – at least long enough to rent for a while – if the monthly payment had not skyrocketed. They were pushed into a corner.

Still, no rent = no business = no business loss.

The best they could do was a capital loss.

What is the one exception to a capital loss I alluded to earlier?

You can deduct $3,000 a year against non-capital-gain property.

Which is no solace when you have an $8-plus million capital loss.

The case is Keefe v Commissioner for the homegamers.

Researching For Deductions

I was skimming a Tax Court case that almost made me laugh out loud.

It initially caught my attention because it involved a deduction for research costs.

The tax surrounding research costs come in two flavors:

·      What is deductible as research?

·      And – perhaps more importantly – can you get a tax credit for it?

Let’s talk this time about the first question, which may not be what you anticipate. Here is an example:

You build a garage to store your business equipment. The garage’s claim to fame is that it is built from natural fibers rather than bricks and lumber. It is the Kon-Tiki of garages. Can you deduct the cost of the garage as you build it?

At the end of the day, you will have a building. Granted, it may be unusual, but it is still a building. Can you deduct a building as you go along? Or do you have to accumulate (and defer) the cost until the building is ready for use? And then what - do you deduct the accumulated cost at that time or do you deduct the cost over a period of years?

You will be deducting the cost over a period of years, otherwise known as depreciation. You self-constructed a long-lived asset, and the tax Code (barring the unusual) will not let you deduct it immediately.

Let’s swing back to research costs.

What if the research costs result in a patent?

You have legal rights for a period of years to intellectual property, and the patent may be worth a fortune.

So we rephrase the question: can you immediately deduct the research costs resulting in that patent?

But CTG, you say, the two are not the same. Chances are that salaries make-up most of the research costs. It doesn’t seem right to capitalize and depreciate salaries. Sticks and bricks have staying power; they last for years. It makes more sense to depreciate those rather than salaries.

Hmmm. What about the wages of the tradesmen-and-women that constructed the building? Do we get to carve those out from the sticks-and-bricks and deduct them immediately?

Of course not.

You now get the issue with research costs.

To answer it the tax Code gives us Section 174:

        (a)  Treatment as expenses.

(1)  In general.

A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.

As long as the costs meet the definition of “research or experimental expenditures,” you have the option of deducting them immediately.

Problem solved.

Our case this time is Bradley and Hayes-Hunter v Commissioner.

Mr. Bradley was a litigation consultant. He reviewed evidence, provided expert testimony and conducted legal research. He was self-employed, and on his 2014 individual income tax return he deducted $25,000 as “Research.”

The IRS was curious what “research and experimental expenditures” a litigation coach could possibly have. It is well-trod ground that Section 174 addresses research in an “experimental” or “laboratory” sense. While one does not have to be in a Pfizer lab wearing a white coat, one likewise cannot be in a library shepardizing law cases.

What did he deduct?

I will give you a clue: his billing rate was $250 per hour.

He deducted $25,000.

And $25,000 divided by $250 is 100 hours.

Not only was he nowhere near a Section 174 research cost, he was also deducting his own time.

How I wish.

Who knows how much tax research I do over an average year. If I could only deduct my time, I would never pay income taxes again.

It won’t work for me, and it did not work for Mr. Bradley.

A CPA Draws A Fraud Penalty

I see that a CPA drew a fraud penalty.

There is something you don’t see every day.

The CPA is Curtis Ankerberg. He practices in Oregon, which means that I could not have met him. I however am certain that I have met his acolytes.

He graduated in 1994 and did the CPA firm route until 2005, when he went out on his own.

Good for him.

The IRS pulled his personal 2012, 2013 and 2014 returns.

Should be easy for a practicing CPA.

During those years he prepared 50 to over 70 individual returns for clients. It doesn’t sound like a lot, but those are just individual returns. It does not include business returns or any accounting he may also have done.

He maintained an office-in-home, which meant that the IRS examiner came to his house. The audit started off on a bad foot. The auditor added up his 1099s for one year and found that the sum exceeded what Ankerberg had reported as income. Needless to say, the auditor immediately recorded a write-up.

Comment: Folks, if you want to chum the waters for an IRA auditor, this is a good way to do so. I am – if anything – surprised that the IRS computers did not catch this before the auditor even showed up.

Emboldened, the auditor now presented a list of documents he wanted to review.

Our CPA said sure, but he never followed up. He was creative with his excuses, though:

·      He had cataract surgery coming up.

·      He was awaiting the outcome of a complaint he filed with the Treasury Inspector General for Tax Administration.

·      He lost his records.

·      The auditor was messing around with one of the years, as the CPA had already agreed he had underreported income.

·      He had not attached necessary forms to his tax returns because to attach them was a “red flag.”

·      He had bank statements but he could not turn them over because he could not see well.

Alrighty then.

That last one cost him and big.

If the IRS wants your bank statements, they will get your bank statements. You can play it nice and provide copies yourself, or you can stick it to the man and have the IRS subpoena them from the bank. The latter may give you a momentary rush of I-am-a-bad-dude, but you have hacked off an auditor.

What is the first reason that comes to mind if one refuses to provide bank statements?

Exactly.

The IRS agent poured over those bank statements like they were winning lottery tickets. Our CPA had again underreported income. In each year.

Can you feel the penalty coming? Oh, it is going to be a biggun.

What more can a disgruntled agent do?

The agent disallowed the following expenses:

·      Insurance

·      Taxes and licenses

·      Office expenses

·      Repairs and maintenance

·      Utilities

·      Interest

·      Vehicle expenses

·      Office in home

·      And others

This is not fatal. Just provide the documents.

Which Ankerberg did not do.

Our CPA is before the Tax Court explaining how he got into this mess. I imagine the conversation as follows:

“Your honor,” he said, “I had serious medical issues, and those issues constitute reasonable cause. I had cataract surgery, and before then I was really a mess. This auditor caught me at a bad time.”

“Really?” asked the Court. “We are curious then how you prepared all those tax returns for all those clients.”

“Braille,” replied our CPA.

“You continued to drive a car,” continued the Court.

“Self-driving,” explained our CPA. “It is a Google car.”

“Interesting,” noted the Court. “How about that 2014 return, the one after your cataract surgery?”

“Phantom blindness,” offered the CPA generously.

“Let us see. Too little income. Too many deductions. A tax professional who knew the tax ropes. Someone who never provided bank statements or other documentation requested by the auditor. What does this sound like? Let us think… let us think...”

“Aha! We remember now: they sound like badges of fraud.”

Bam!

BTW the fraud penalty is 75%.

Just provide the bank statements, Barney.

Fewer Like-Kind Exchanges in 2018

The new tax bill changed like-kind exchanges.

This is Section 1031, which was and is a tax provision that allows one to defer taxes on a property sale - if one follows the rules.

I suspect that almost every practicing tax accountant has met with a client who said the following:

·      I sold property last year,

·      I hear that there is a tax break if I buy another piece of property

Well, yes there MIGHT be a tax break, but you have to follow the rules from the beginning, not just months later when you meet with your accountant.

The normal sequence is to sell the property first. It doesn’t have to be that way – you can start with the buy – but that is unusual. The tax nerds refer to that as a “reverse.”

There are ropes:

(1)  You want the money held by a third party, such as an attorney or title company;

(2)  You have to identify the replacement property within 45 days (there is some latitude in identifying replacement properties); and

(3)  You have to complete the whole transaction – sell and buy – within 180 days.

(4) Anticipate that you will be buying-up: buy more than what you sold.

(5)  Debt is tricky. To be safe, increase your debt, at least a little bit.  

(6)  You never want to receive cash from the deal. Cash is income – period.

If you wait to until you meet with your accountant, then you have probably blown requirement (1).

The most common like-kind that I see – I kid you not – is vehicle trade-ins. They happen every day, to the point that we do not even pay them attention. In the tax world, however, trade-ins are like-kind exchanges.

The next most common are real estate exchanges. I have probably seen at least one a year for the last couple of decades. Those usually go through a title company or attorney, and I have the pleasure of looking over a binder of paperwork that would weigh down a Clydesdale.

There are others. One can like-kind exchange personal property, for example. The rules are stricter than the rules for real estate, and for the most part I have not seen a lot of those.

The new tax bill made a big change to like-kind exchanges.

How?

Because personal property no longer qualifies for like-kind treatment.

So much for trade-ins.

But there is another kind that I thought of recently.

Think sports.

Yep, back in 1966 the IRS considered player contracts – if done correctly – to be property qualifying for like-kind.

I am unsure how professional sports will work-around this change. It is not an area I practice, although I would have loved to.

Why did Congress mess with this?

It wasn’t about player contracts. It rather had to do with art and collectibles. It had become de rigueur to like-kind exchange in the art world, as buyers had come to view art as just another tradable commodity. Think stocks, but with the option of delaying taxes until the end of time. This reached the attention of the Obama administration, which began the push to eliminate them.

It took another White House, but it finally got done.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.

A Divorce Decree And Past Taxes

Let’s say that a couple divorces. The divorce decree stipulates that liability for previous federal taxes will be split 50:50. They had always filed jointly The IRS audits one or more of those earlier years and assesses additional taxes.

Question: what is each spouse’s liability?

Your first thought might be 50:50, as that is what the divorce decree says.

Our protagonists this time would find out.

Mae Asad and Sam Akel filed joint returns for 2008 and 2009. The IRS audited those years, looking at rental losses. They disallowed the losses and assessed over $30,000 in taxes and penalties.

Mae filed for innocent spouse.

Later Sam filed for innocent spouse.

NOTE: Filing for innocent spouse status means that a spouse (probably an ex-spouse, but I had a client who was still married) has been assessed taxes for which he/she does not believe he/she is responsible. The classic case is the stay-at-home spouse, the other self-employed spouse, and the stay-at-home has no participation in or knowledge of the other’s business. Think Carmela Soprano.

The IRS bounced both requests for innocent spouse.

Both ex-spouses filed with the Tax Court.

Before the hearing, the IRS conceded that Mae was responsible for 28% of the 2008 tax and 41% of the 2009 tax. Sam of course was responsible for the balance.

Seems to me that Sam might not like this deal.

I do not know how, but Mae agreed to a 50:50 split. She did not have to, mind you.

The courts have been consistent that a divorce decree is not binding on the IRS, as the IRS is not party to the divorce.  A joint return means that both spouses are liable, and the IRS can go after one … or both, to the extent the IRS desires. The decree may provide for a former spouse to seek restitution against the other, but it has no impact on the IRS.

The Court accepted the IRS previous concession to Mae of 28% and 41%. It did not have to observe the divorce decree and it did not.

Then the Court reviewed the penalties of over $5,000.

But there had been a fatal flaw,

You see, Mae and Sam had filed pro se with the Tax Court. Pro se means one is going in without professional representation (not exactly correct, but close enough). It happens with small tax cases. The paperwork to get to Court and the procedural rules once there are more lenient for small cases.

Sam and Mae had not included the penalty in their petition to the Court.

The Court did not have authority to review the penalties.

But it did provide us a clear example of the downside to representing oneself pro se.

An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation?